*921 The taxpayer was the holder of bonds of a state irrigation district and in the taxable year 1934 deposited his bonds with the district under an agreement by which they would be retired at a fixed percentage of their par value. The bonds were accordingly retired in the next year. Held, that since retirement was contemplated at the time the taxpayer first ascertained the bonds' partial worthlessness, not section 23(k), Revenue Act of 1934, relating to bad debts, but section 117(f), providing for the retirement of bonds, is applicable; and the loss resulting will be a capital loss determined as therein provided. Quaere, whether section 23(k) would have been applicable had the taxpayer not known of any proposed retirement in the taxable year and had charged off the loss?
*1164 These two cases were consolidated for hearing and decision, and involve in each case deficiencies in income tax of $257.36 for the calendar year 1934. Each petitioner claims an abatement of the deficiency determined by the respondent and an overpayment, after a correction made*922 and accepted at the hearing, of $1,464.43. Respondent has stipulated that taxes equal to these sums claimed were paid by each petitioner.
FINDINGS OF FACT.
The petitioners are husband and wife residents of the State of Washington, and under the community property law of that State, each owned half of the property in respect of which deductions are claimed, consisting of bonds of the Spokane Valley Irrigation District and the Trentwood Irrigation District.
Except for the question of charge-off, none of the facts are in dispute. The Spokane Valley bonds were bought by the petitioners in 1923 at a cost, the parties have stipulated, of $57,300, and were retired, principal and outstanding interest, by the district on May 3, 1935, for $35,616. Similarly, the Trentwood bonds were bought by the petitioners for $36,720, and were retired on January 3, 1935, more than ten years after purchase, by the district for $30,479.38. Both lots of bonds were held as community property by the two petitioners. It was stipulated by counsel that both irrigation districts in question were "insolvent" (in the equity, and not bankruptcy, sense of that word) in 1934, so as to be unable to pay their*923 respective bonds, principal or interest, as these obligations might mature. Each of the irrigation districts in question early in 1934 determined to obtain its bondholders' consent to cancellation of a part of its bonded obligation and to obtain from the Reconstruction Finance Corporation the necessary cash to pay off the remainder. Petitioners deposited their bonds of the Spokane Valley Irrigation District on May 28, 1934, pursuant to the proposal outlined in the following letter, which also describes the financial condition of the district:
SPOKANE, WASHINGTON, March 30, 1934.
TO THE BONDHOLDERS,
Spokane Valley Irrigation District:
The Board of Directors of the Spokane Valley Irrigation District herewith submits to the bondholders a brief statement of the present financial condition of the district, and a plan to refinance the district's indebtedness.
This district is located in the Spokane Valley, comprises 4465 acres and was organized in 1922. At that time bonds in the sum of $528,750.00 were issued. This amounted to approximately $125.00 per acre on all of the irrigable lands within the district.
In 1925, 203.65 acres were added to the district, and local*924 improvement bonds in the amount of $22,500.00 were issued by the district to supply water to these additional lands.
*1165 When the district was organized and bonds issued, it was estimated that the annual assessments necessary to retire the bonds and to pay the interest and cost of maintenance would not exceed $10.50 per acre. After several years' operation, it was found that the minimum assessment necessary to maintain the system and pay the principal and interest on the bonds as they matured, was $9.00 per acre for bonds and interest, and $3.00 for maintenance, or a total of $12.00 per acre. That assessment has been levied constantly by the Board of Directors up to and including the year 1934.
The district was able to meet its obligations up to January 1, 1933, when default was made in the payment of interest. July 1, 1933, the district defaulted in the payment of $7,000.00 due on the principal of its bonds. Default has also been made in payment of interest due July 1, 1933, and January 1, 1934. An additional principal installment of $7,500.00 will be due on the bonds on July 1, 1934.
The bond and interest account at the end of 1932 was short $12,452.65. At*925 the end of 1933 the deficit had increased to $37,527.01.
The deficit in the expense fund at the end of 1932 was $4,019.73. By the end of 1933 this had increased to $10,317.22. Included in this deficit was $9,951.55 unpaid warrants. It is going to be impossible to continue operations on a warrant basis since our employees and the dealers furnishing us with necessary supplies are finding it increasingly difficult to get their warrants cashed.
The above condition is due to the inability of landowners to pay their assessments. At the end of 1932 delinquencies were $26,898.82. At the end of 1933 $61,908.90. But 31% of the assessments for 1933 were collected during the year.
As a result of the failure of the landowners to pay their assessments, 750 acres of land has been deeded to the district. Until this land is sold, no water revenue will be received therefrom by the district. High water charges and insolvency of the district makes it practically impossible to sell any land at this time. On the basis of $12.00 per acre, this means a loss of $9,000.00 revenue annually.
The bond lien is still about $113.50 per acre.
Our Board of Directors realized in December, 1932, *926 that something must be done to relieve the situation and prevent the district from a receivership and forced liquidation. Accordingly, we have made every possible effort to work out a satisfactory plan of refinancing.
On April 8, 1933, an application was made to the State of Washington, for aid through the Reclamation Revolving Fund. This application was turned down since the amount involved was out of proportion to the funds available.
The Board then applied to the Reconstruction Finance Corporation at Washington, D.C., for a loan. A complete report was made to the RFC covering our situation. Later the appraiser for the RFC came here and spent nearly two weeks going over the entire district, inspecting ditches, flumes, etc., interviewing landowners, and checking accounts and records. His report was then sent to Washington, and on March 8, 1934, the Board of Directors of the Reconstruction Finance Corporation passed a resolution outlining specific conditions under which a loan would be made in a sum not to exceed $308,945.70 at 4% to refinance the district. A certified copy of this resolution has been received by our Board of Directors.
The amount of this loan will be*927 sufficient to pay all of the bondholders of the district $59.36 in cash for each $100.00 of the principal of the bonds. All unpaid coupons which you hold must accompany the bonds. This loan does not provide for any payment on interest coupons.
*1166 The resolution provides that all bonds which are not turned in when the loan is made, will be paid not to exceed $57.36 per $100.00 including coupons. This provision gives a premium of $2.00 per $100.00 for promptness in depositing bonds. Provision is further made so that in case all of the bonds are not deposited, those which are deposited, may be paid for but not cancelled. The evident purpose of this provision is to prevent bondholders who refuse to turn their bonds in, from securing any advantage over those who do so.
The above offer made by the Reconstruction Finance Corporation should be accepted promptly, otherwise their offer will be withdrawn. We, therefore, suggest that you sign the enclosed Bond Owner Consent form and return at once, together with your bonds, either to Paul J. Kruesel, Spokane County Treasurer, or to the Old National Bank and Union Trust Company, Trust Department of Spokane, Washington, who*928 have been designated as Owners Agents for this refinancing.
The financial plight of the district, growing more serious day by day, will lead to disaster unless relieved, and the refunding plan, above described, is respectfully submitted and represented as being the only possible recourse for assistance known to this Board. Acceptance of this RFC assistance is, therefore, respectfully recommended, and bond owners are urged to deposit their holdings without delay.
Very truly yours,
SPOKANE VALLEY IRRIGATION DISTRICT,
By CARL W. PETTIBONE,
Chairman, Board of Directors.
Attest: Y. L. GRANT,
Secretary.
The Trentwood District, situate about seven miles east of Spokane, was much smaller, comprising only 930 acres. The particulars of its insolvency are wanting, but it appears from the bondholders' deposit agreement that the Reconstruction Finance Corporation by resolution of March 30, 1934, authorized a loan of not to exceed $36,000, or a sum which would enable the district to retire its bonds at $.68493 for each dollar of the principal, plus interest to date of consummation of loan. The petitioner, Austin Corbin, 2d, deposited under this agreement on April 23, 1934.
*929 It appears that had the petitioners declined to accept the bondholders' agreement in either case they would have had to rely on their rights at law to foreclose on individual tracts included within the District and upon which the annual assessments were delinquent; and after such foreclosure and after paying off general taxes and other liens on the lands so acquired, to sell the land, for the most part small trucking areas cultivated by Italians, as they could. The petitioners were informed of their rights before making their deposits of bonds.
The bonds of each district became worthless in 1934 to the extent of any excess over the percentage which the district agreed to pay under its agreement with the Reconstruction Finance Corporation.
*1167 Both petitioners filed for 1934 income tax returns in which the losses on both lots of bonds were claimed as capital losses. The Commissioner allowed a capital loss of $2,000 on the Trentwood bonds, but refused any deduction for the Spokane Valley bonds on the ground that the loss, if any, was not incurred before 1935. Thereafter amended returns were filed by the petitioners in which the same losses were claimed as bad debts. *930 This change, however, was not made until 1936, when Austin Corbin and his secretary discussed the matter in the light of the latter's increased experience with income tax matters and decided to make the change. Petitioners were on the cash basis. Neither petitioner kept any books, but Austin Corbin made, or had pasted in, occasional entries on his check stubs. Such entries were made by Austin Corbin in 1935 in respect of both lots of bonds, as follows:
| Trentwood Irrig. Dist. | |
| Bonds amounting to | $44,500.00 |
| Dep. 1-3-35 | $30,479.38 |
| See opposite | 1,335.00 |
| Amount rec'd from District 68.49% of face value or | $30,479.38 |
| Interest on face value 7/1/ 34 to 1/1/35 at 6% | 1,335.00 |
| Spokane Valley Irrig. Bonds: | |
| Dep. 5/3/35 - Spok. Valley Irrig | $37,416.00 |
| Bonds - $60,000 at 59.36% | 35,616.00 |
| Interest | 1,800.00 |
| 37,416.00 |
OPINION.
KERN: The sole question before us, identical as to each petitioner, another question raised on the petitions having been settled at the hearing by stipulation, is whether the losses sustained by each petitioner in 1934, of $10,842 on Spokane Valley Irrigation District bonds and of $3,120.31 on Trentwood Irrigation District bonds, are*931 allowable as bad debts under section 23(k) of the Revenue Act of 1934, or as capital losses under section 117(f) of the same act, and, if the latter, therefore limited to $2,000 plus capital gains. The pertinent statutory provisions are set out in the margin. 1
*932 *1168 Respondent contends that gains or losses sustained by a bondholder on the retirement of his bonds at less than their face value are, under section 117(f) Revenue Act of 1934, capital gains or capital losses; but if it shall be held that such losses were bad debts, he argues that adequate proof of a charge-off is lacking; and, even conceding that a "mental" charge-off - that is to say, a subjective charge-off by intention without any overt act by the taxpayer - is proper, that the evidence here rebuts the existence of such an intention in 1934.
Since the first proposition, if sustained, will dispose of the case, we shall consider it first. In , the Supreme Court in affirming the court below (), assumed the validity of section 117(f), Revenue Act of 1934, taxing "amounts received by the holder upon the retirement of bonds * * * as amounts received in exchange therefor", that is to say, as capital gains; but pointed out that the provisions had no retroactive effect.
There is no specific reference to bonds in section 23(k) of the statute. *933 However, article 23(k)-4 of Regulations 86 (set out in full in the margin 2) provides that "bonds, if ascertained to be worthless, may be treated as bad debts to the amount actually paid for them" - a survival of an earlier regulation. Cf. Regulations 69, art. 154; Regulations 74, art. 194. To the same effect see ; . The statute, by section 117(f), on the other hand, clearly intends to treat the "retirement" of bonds as an "exchange" resulting in either capital gain or capital loss. There can be no doubt that the bonds in question have were "retired" within the meaning of the act, and consequently, the loss sustained on such retirement must be reckoned *1169 under section 117(a), as specifically provided. Cf. .
*934 Petitioner contends, however, that the provision of the regulation and that of the statute in respect of bonds are not incompatible; that consequently, the irrigation district bonds were ascertained in 1934 to be worthless to the extent which we have found; and if any difference arises between the loss sustained on the determination of worthlessness in that year and the loss resulting from the retirement of the bonds in the next year, 1935, it can be adjusted in the latter year. But this contention overlooks the fact that petitioner's ascertainment of worthlessness was coincident with his acceptance of the retirement agreement. There may be situations in which the partial worthlessness of the bonds resulting from the obligor's financial condition will justify charge-off, in the year of such ascertainment, and where the corporation will in a later year determine to retire them at less than par; so that the two provisions for deduction of the loss will successively be brought into play and the relation of their operation be determined. Although such a situation would seem unlikely to arise, we may concede its possibility; but this concession can not persuade us to accept the application*935 of two distinct and disparate methods of deduction in successive years, where the obligor's intention to retire the bond issue was clearly evidenced at the very time when the ascertainment of its financial condition would first have justified a partial charge-off of its obligations. Without deciding, therefore, that the two methods are mutually exclusive in all circumstances, we think they clearly were in the present instance; and that the capital loss deduction, foreseeable as a result of the bonds' retirement, could not be anticipated by a bad debt deduction for worthlessness; that this would defeat the intention of Congress in enacting section 117(f) and can not be accomplished under the clear intendment of that subsection. We hold, therefore, that the losses on both lots of bonds were capital losses and were sustained in 1935 when the bonds were retired, and limited, as provided, in the amount of their deduction. Although the petitioners had done in 1934 what acts were necessary on their part to obtain payment of both the Spokane Valley and the Trentwood bonds by depositing them according to the respective agreements, it is not clearly shown that they thereby acquired the right*936 in either instance to make an unqualified demand on the district for the agreed retirement amount.
In this view of the case we deem it unnecessary to discuss the question of charge-off. Since there is no issue as to the deduction in 1934 of the statutory capital loss sustained on the Trentwood bonds, the deficiency determined will be affirmed, and
Decision will be entered for the respondent.
Footnotes
1. SEC. 23. (k) BAD DEBTS. - Debts ascertained to be worthless and charged off within the taxable year (or, in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts); and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction.
* * *
SEC. 117. (a) GENERAL RULE. - In the case of a taxpayer, other than a corporation, only the following percentages of the gain or loss recognized upon the sale or exchange of a capital asset shall be taken into account in computing net income:
* * *
30 per centum if the capital asset has been held for more than 10 years.
* * *
(d) LIMITATION ON CAPITAL LOSSES. - Losses from sales or exchanges of capital assets shall be allowed only to the extent of $2,000 plus the gains from such sales or exchanges. * * *
* * *
(f) RETIREMENT OF BONDS, ETC. - For the purposes of this title, amounts received by the holder upon the retirement of bonds, debentures, notes, or certificates or other evidences of indebtedness issued by any corporation (including those issued by a government or political subdivision thereof), with interest coupons or in registered form, shall be considered as amounts received in exchange therefor. ↩
2. Art. 23(k) -4, Worthless bonds and similar obligations. - Bonds, if ascertained to be worthless, may be treated as bad debts to the amount actually paid for them. Bonds of an insolvent corporation secured only by a mortgage from which on foreclosure nothing is realized for the bondholders are regarded as ascertained to be worthless not later than the year of the foreclosure sale, and no deduction for a bad debt is allowable in computing a bondholder's income for a subsequent year.
A taxpayer (other than a dealer in securities) possessing debts evidenced by bonds or other similar obligations can not deduct from gross income any amount merely on account of market fluctuation. If a taxpayer ascertains, however, that due, for instance, to the financial condition of the debtor, or conditions other than market fluctuation, he will recover upon maturity none or only a part of the debt evidenced by the bonds or other similar obligations and so demonstrates to the satisfaction of the Commissioner, he may deduct in computing net income the uncollectible part of the debt evidenced by the bonds or other similar obligations. ↩